Thursday, October 24, 2013

Update on Rollover IRA

Some readers might remember this post from early February where I talked about opening a Roth IRA. At that time I knew I was going to be moving and changing jobs mid-year, so I mentioned that later in the year I was going to rollover the two retirement plans associated with my previous employer into my Roth IRA. Now that I've settled down financially after my move, I've set the wheels in motion for the rollover.

I've opened a Rollover IRA with Scottrade (the brokerage I use for my other accounts) and I've initiated direct rollovers of the 403(b) plan held by TIAA-CREF and the 401(k) plan held by Vanguard. Once those institutions have verified some information, they will send checks to Scottrade that will be deposited in my Rollover IRA. I was told it would take about 1-2 weeks for that to happen. After the funds are deposited, I will then convert (or merge) my Rollover IRA into my existing Roth IRA. My hope is that the rollover and conversion will be completed by mid-November, at which point I will have a sizable chunk of money in my Roth IRA to reinvest.

The move of pre-tax money into my post-tax Roth IRA will result in the money being treated as taxable income for 2013. Even though I do not like taking a big tax hit, it is a one-time expense that makes financial sense. Using various online calculators, I determined that the taxes I pay now will be much smaller than the taxes I would likely pay on withdrawals from a traditional IRA in 30+ years. By converting to a Roth IRA, I can look forward to making tax-free withdrawals in the future from an account that will benefit from 30+ years of tax-free compounding. Besides, I have already set aside enough money to pay the estimated taxes on the rollover money, so it will not affect my current rate of new capital investment.

I will post another update once the rollover and conversion have been completed.

21 comments:

I really want to convert my rollover IRA to a Roth but it just doesn't make sense financially right now. Our income is much higher than it'll be in retirement or early retirement should we go that route so for the time being it's just going to stay invested in some index funds with Vanguard and compound until we get to a better tax situation.

Do you happen to know if funds in a Rollover IRA are counted total IRA contributions? Here's the situation, I've got about $12k in a Rollover IRA from about 4 years ago and I'm thinking of maxing out a traditional IRA and converting to a Roth. So the question is will the Rollover funds count as non-taxed contributions so I then I can only convert a portion of the traditional IRA to the Roth? Income is too high for us to contribute directly to a Roth so we have to do a backdoor conversion. I should have taken the tax hit while I was unemployed and my tax rate was essentially 0%.

PIP: To the best of my knowledge, rollover money does not count toward the annual contribution limit. For example, I've already reached the $5,500 contribution limit for my Roth IRA this year. However, I am allowed to rollover and then convert my old plans into my existing Roth IRA because that money doesn't count as a contribution. In your case, I don't think your rollover money would be treated as a contribution. Thus, you should be able to max out a traditional IRA and do the backdoor conversion to a Roth IRA, regardless of what you do with the Rollover IRA. However, I am not a tax expert, so be sure to familiarize yourself with the IRS documentation and rules.

I know if you have a traditional IRA that has funds that haven't been taxed and then contribute say the following year to a traditional and immediately convert to a Roth you can only convert the ratio of already taxed and pre tax contributions. Rolling over doesn't make sense right now though because of our tax rates. Guess ill need to shoot my aunt an email.

PIP: The roll over money should not count against your yearly contribution limit.

On your point of higher income tax rate now vs later. To be honest, I have never understood this line of reasoning. You are avoiding paying taxes on $5,500 and choosing to pay taxes on $55,000+ when you pull it out in retirement. While the tax rate might be different that total taxes paid will be far greater

PIP: It's a good idea to ask others for additional information. It took me a while to figure out the whole rollover process, but I focused on details specific to my circumstances.

PMU: I agree -- I'd rather pay a small amount of tax now than a much larger amount of tax later (due to compounded growth of the account value over 30+ years), even if the latter might be at a lower tax rate.

The reasoning is that we'll end up being in the 28% bracket this year and probably for the foreseeable future. We can probably game the tax code right and convert to a Roth at a point in time where we're in the 15% bracket. That's pretty much halving the tax bill. Plus it's only on about $11-12k and the conversion will hopefully be done in the next 5 years.

Also it looks like Rollover IRAs are still counted in the calculation for how much you can convert to a Roth so I could only convert around 45% of the contribution to the Roth.

But contributing to a traditional IRA gives you the advantage to compound on your deferred taxes as well. If you believe that you can grow your tax deferred contributions at the rate higher than the tax increases in the next 30 or so years, isn't it rather advantageous to pay taxes at the end. Besides, in retirement there is always the option to withdraw money that would make you fall in the lower tax bracket.

I know this is all individual specific, and I might be seeing an advantage for myself but may not work for someone else. Also, I have heard people say that you should perhaps diversify the tax deferred accounts too just to be able to benefit both.

Anonymous: I also wondered whether a traditional IRA might be more advantageous, so I played around with online calculators that compare traditional vs. Roth IRAs. I also solicited advice from folks who know more about personal finance than I do. Overall, there was a slight advantage to doing the Roth conversion, but that may be specific to my individual circumstances.

I've also heard that it can be beneficial to diversify among tax-deferred accounts. The two retirement plans I have with my new employer are tax-deferred accounts that get pre-tax contributions, so that will give me some diversity in that respect. Moreover, I gain diversity in a different respect because those plans are invested in index funds, giving me exposure to more of the market than my individual-stock portfolio. (The plans do not allow me to invest in individual stocks, only a limited selection of funds.)

I was referring to the amount of your contribution that can be converted to a Roth. Youre correct that the rollover funds don't count against you're annual contribution but they're still factored in to what can be converted to a Roth. Thanks to our simplified tax code everything is so straightforward and easy.

Interesting that you are considering to move out money from your targeted date funds almost towards the end of the year, when most of these funds usually distribute the year long dividend in December every year. Have you given thought to this? Why not rollover after collecting your dividends?

Anonymous: Thanks for your comment. I didn't realize that target-date funds paid their dividends at the end of the year; looking back at old statements, I see you're right. However, for tax reasons I want to get this done before the end of 2013, otherwise I would be pushed into a higher tax bracket in 2014. Moreover, I won't be able to do it in late December (after the dividend payment) because I'll be away for the holidays. Looking at the numbers, the dividend payment is likely to be rather paltry, so I'm not sacrificing much by doing the rollover now. But I appreciate the point you raised.

You are absolutely right, the money saved by taking advantage of your lower income this year (due to the employment gap from the summer and previous lower salary) is far greater than the dividend payment you will be missing.

w2r: In addition, if the market dips just 2% between now and the end of the year, the lost capital gains would overshadow the annual dividend payment I would receive. Thus, it may be advantageous for me to do the rollover at a market peak.

w2r: Yes, that's another reason why I favored the conversion. My Roth IRA is relatively small at the moment and, due to annual contribution limits, dividend reinvestment occurs infrequently. The conversion will substantially increase the size of my Roth, eventually leading to more dividends and improved reinvestment options.

I recently did the same thing in May (anxiously awaiting my tax bill in Feb). When I left my last job I rolled everything into a traditional IRA, then $X into a Roth. I use the Traditional for index funds and berkshire, and my Roth for dividend growth stocks. I won't be touching this for 30+ years so as you pointed out, the tax hit today is worth the tax-free withdrawals (ideally from dividends alone, no principal) in retirement. Goodluck.

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